Because America has the world’s largest economy, every economic move that the US makes has immediate effects on the global markets. At the moment, there's speculation, worldwide, about whether or not the US is about to raise interest rates—and with all indicators pointing to a rate increase, there are concerns about ripple effects throughout the rest of the world.
At a basic level, raising interest rates go hand-in-hand with appreciating currencies. And in many parts of the world, the US dollar is used as a benchmark of current and future economic growth. In developed countries, a strong dollar is seen in a positive light. But circumstances are different in emerging economies.
The Appreciating Dollar
In the aftermath of the 2008 Financial Crisis, the Federal Reserve implemented years of quantitative easing to stimulate economic recovery, slashing rates to a near-zero, where they remained for the next six years. The idea was to spur investments, along with consumer spending, and drag the America economy out of recession. In the years that followed, the economy did begun to recover, and, as a result, the Federal Reserve has indicated that it will raise interest rates once again. Historically, rising interest rates have gone hand-in-hand with an appreciating US dollar. This, in turn, affects economic facets domestically and around the world—particularly the credit market, commodities, stocks, and investment opportunities.
The value of US Treasury Bonds is directly connected to changes in US interest rates, and in the US, the Treasury yield curve is quick to reflect changes in domestic interest rates. As the yield curve moves up or down, global rates are set, accordingly. Since Treasury bonds are considered a risk-free asset, any other security must offer a higher yield to remain attractive, and with interest rates expected to increase, causing global investors to park their money in the US, emerging markets will feel a great deal of pressure to remain attractive. Ultimately, this could hinder employment levels in developing nations, along with exchange rates and exports.
Dollar Denominated Debt
Because the US economy is continuing to show signs of growth, increasing the interest rates may be the right move, for America, as the QE comes to an end. At the same time, emerging markets will suffer. Dollar denominated debt outside the United States currently amounts to $9 trillion, with emerging markets amassing $3.3 trillion. Countries such as Turkey, Brazil, and South Africa, which perpetually run trade deficits, finance their current account deficits by building up dollar-denominated debt. In situations where US interest rates increase while the dollar appreciates, the exchange rate between developing nations and the US tends to widen. As a result, dollar-denominated debt owed by developing nations increases and becomes unmanageable.
The Credit Market
The fear of rising interest rates can be rooted in their contractionary effects on credit and money supply. According to Econ 101, higher interest rates lead to a decrease in the money supply and appreciation of the dollar. Art the same time, lending and credit markets contract. Global credit markets follow the movements of Treasury Bonds. And, as interest rates increase, the cost of credit does, too. From bank loans to mortgages, it becomes more expensive to borrow. Hence, an increase in the cost of capital can hinder consumption, manufacturing, and production.
The most profound consequences of interest rate hikes in America are likely to come at the expense of Asian economies, accelerating capital outflows from China and creating more instability in that nation, which is already experiencing financial turbulence. During the past six years, China has borrowed from foreign banks to stimulate growth. This borrowing was fueled by lower interest rates. But with tighter credit conditions looming, foreign lending to heavily indebted countries will drop off significantly.
The Commodities Market
Oil, gold, cotton and other global commodities are priced in US dollars, and a strong currency following a rate increase would increase the price of commodities for non-dollar holders. Economies that rely primarily on commodity production and an abundance of natural resources will be worse off. As the products of their principle industrial decline in value, their available credit streams will shrink.
Despite the ways in which US interest rates negatively impact the global economy, rising interest rates do benefit foreign trade. The stronger dollar that will accompany the rate increase should boost US demand for products around the world, increasing corporate profits for domestic and foreign companies alike. Because fluctuations in the stock market reflect beliefs about whether industries grow or contract, the resulting profit spikes will lead to stock market will rallies.
The Bottom Line
Interest rates are fundamental indicators of an economy’s growth. In the US, the Federal Reserve’s move to increase interest rates is expected to spur growth and exuberance on the part of investors, while tempering the economy itself. (Higher interest rates can help an economy avoid overproduction traps and asset bubbles fueled by cheap debt.) While the Fed’s primary concern is the US economy, it will also be paying close attention to the effect its rate increase will have on foreign trade, and on the world's credit and commodities markets.